The Cap Rate Series: Shopping For The Strongest Buy In The Shopping Center Sector

by: Brad Thomas

As I have often argued here on Seeking Alpha, there are just too many shopping center REITs.

Recognizing the playing field is crowded, we thought it would be interesting to conclude this article with some possible M&A deals.

We are upgrading Weingarten Realty to a Strong Buy, as a result of this WACC/Cap Rate exercise.

Do me a favor and do an online search for “shopping centers”… making sure to put it in quotes when you do. That way, you’ll find more accurate results.

One thing that will probably come up is a link to Google Maps – or some equivalent – showing you all the shopping centers in your area. Depending on where you live, it could be a lot.

For instance, if you were going to do this search in Lancaster County, Pennsylvania, traditional home of the Amish, it would show about 19 locations at first glance. That’s contained within, I’d say, a 50-minute driving range expanding out east-ish and west-ish from Lancaster City proper.

What can be found in those shopping centers?

I can’t tell you for sure without actually visiting each and every single one. But here’s some definite and even probable possibilities that come to mind:

  • Grocery stores
  • Card and gift stores
  • Dollar stores
  • Shoe stores
  • Hardware stores
  • Drycleaners
  • Eateries
  • Sit-down restaurants
  • Coffee shops
  • Perhaps a remaining K-Mart or two
  • AT&T (NYSE:T), Verizon (NYSE:VZ), Sprint (NYSE:S) and similar services…

Maybe even a movie theater here or there. It’s really rather up for grabs when shopping centers can hold just about anything, whether necessity or absolute luxury. Though many of them are strategically set up to cater to both, with a grocery store or pharmacy as their “anchor.”

This way, customers are bound to keep returning to these plazas for what they need… and probably stop by from time to time at least for what they want as well. After all, how often can you pass an ice cream shop without breaking down and stopping in for a scoop?

That kind of need and craving combined can make shopping centers powerful profit houses to be reckoned with. And it’s REITs that almost inevitably own them.

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Photo Source

Yes, I Know That Retail REITs Are Hurting

As our title indicates, we’re continuing on with our cap rate focus. And shopping center REITs (real estate investment trusts) are next on our investigative list.

Need a refresher or even a starter’s course on what cap rates are and why they matter? I suggest you click right here. That link is for our second installment in the series, and it does a pretty good job of explaining what cap rates are. (If I do say so myself.)

Meanwhile, if you need any further information about shopping centers, don’t worry. We’re not referring to mall REITs. Though, believe it or not, some of those are actually going strong despite the game-changing (yet perhaps overhyped) “retail apocalypse.”

With that said, it is true that shopping center and mall REITs both fall into the larger retail REIT category. And it’s also true that many retailers are struggling. Last year wasn’t as bad as 2017, when more than 20 retailers “went bust,” as CNBC – accurately – phrased it on December 31.

This included Toys ‘R’ Us, H.H. Gregg, and Gymboree.

Then, in 2018, we got another round of disconcerting retail news with once iconic or otherwise popular stores filing for bankruptcy or having to shut down completely. Here are a few of those unfortunate entities:

  • David’s Bridal
  • Sears
  • Mattress FIRM
  • Claire’s
  • Bon-Ton.

Again, not all of them shut down. And it’s also important that not all of them are shopping-center staples. Some of them are very mall-specific.

Some of them, however, are quite the opposite.

Shopping Center-Specific

Take David’s Bridal, for one, which can be found in shopping centers spread out across the country. Fortunately, in this case, there’s that present-tense keyword: can. The wedding outfitter managed to emerge from bankruptcy without closing a single one of its 300 stores.

That right there? That’s impressive.

As happy as shopping center REITs undoubtedly were to be able to expect further rent checks from David’s in 2019, they weren’t so lucky with the much more prolific Mattress FIRM. While it was ultimately able to maintain more than 2,000 stores, it did end up shuttering about 700.

Which, we already know, did do some damage to the companies it had signed rental leases with.

Late last year, as reported by multiple news outlets, including BedTimes, the Mattress FIRM CEO flat-out admitted how, “We knew that our unprecedented growth had led to duplicative store locations in many of our markets.” Which means that it’s a lesson learned all around, both for the company and the REITs that make space for it.

In fact, there are a lot of lessons that shopping center REITs are learning these days. So while some are certainly struggling, others are adapting with the times, figuring out how to have a healthy business, no matter what.

And since they’re not going anywhere anytime soon, let’s see what their cap rates should be.

Crunching the Cap Rate Numbers

As I have often argued here on Seeking Alpha, there are just too many shopping center REITs. We have a dozen in our coverage universe, and we believe there should be no more than eight of them (note: we excluded Wheeler REIT (NASDAQ:WHLR) from our coverage after the dividend got whacked a few times).

Recognizing the playing field is crowded, we thought it would be interesting to conclude this article with some possible M&A deals. But first let’s get started with the WACC (weighted average cost of capital) exercise. We have already done similar modeling for the net lease REITs, the healthcare REITs, and the industrial REITs. So let’s take a look at the dozen shopping center REITs and their equity cost of capital:

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As you can see, a few names jump out at us, such as Weingarten Realty (WRI), the REIT with the lowest equity cost, followed by Federal Realty (FRT), and Acadia Realty (AKR). Remember that we have Buy ratings on Kimco Realty (KIM), Brixmor (BRX), and Kite Realty (KRG) because of their cheap valuation, and these are reflected in the higher cost of equity (for these 3 REITs). Now let’s take a look at the debt cost for these twelve shopping center REITs:

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Again, Acadia, Weingarten, and Federal Realty are strong standouts because of their low cost of debt, and Regency Centers (REG) looks especially attractive given its lowest debt cost in the sector. Kimco Realty (KIM) – rated BBB+ by S&P – is also a standout as well as Urstadt Biddle (UBA), a small-cap REIT with an impressive 32% debt to asset ratio. Now let’s look at the “sum of the parts,” that is, the total WACC for each of the shopping center REITs:

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The shopping center REITs with the overall lowest cost of capital include Retail Opportunity Investments Corp. (ROIC), Regency Centers, Acadia Realty, Federal Realty, and Weingarten Realty.

Now let’s take this exercise one step further, by utilizing the “yield on cost” (or cap rate) for each REIT. Keep in mind, many of the shopping center REITs have been recycling properties (selling non-core assets) and reinvesting proceeds into development and redevelopment projects.

We examined the earnings transcripts for a number of the shopping center REITs and found that the average cap rates on dispositions for many of the REITs are between 7% and 7.5%. Thus, in evaluating our spread investing model, we decided to utilize the development and redevelopment yields for each REIT.

Some REITs are developing more than others. For example, Kimco has guided $275 million to $350 million in 2019 and Weingarten has guided $200 million in 2019. Regency has guided a similar amount for redevelopment, around $250 million in 2019. Federal Realty has around $132 million underway now (as of Q1-19) with a very robust pipeline of densification projects (of 4.4 million square feet).

Other REITs are still seeking acquisitions selectively, such as Retail Opportunity Investment, Whitestone REIT (WSR), and Urstadt Biddle. As a result, we decided the best way to measure profitability is by applying an appropriate cap rate for each REIT based upon their capital spend guidance or profile.

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As you can see, Weingarten Realty, Federal Realty, and Regency Centers score the most favorable, based on their overall cost of capital and yield on cost. In fact, we were somewhat surprised to see Weingarten screen as #1, beating out the “dividend king,” Federal Realty (FRT has increased annual dividends for over 51 years in a row). Let’s do a quick synopsis for each of these top 3 REITs:

Regency Centers is the largest shopping center REIT with 419 properties located in the nation's most vibrant markets. We like this REIT because of its focus on grocery stores and the company’s annual free cash flow (of $170M) help fund development and redevelopment at compelling yields (averaging 7.5%).

The company has continued to opportunistically sell some of its lower growth assets to further enhance portfolio quality and Same Property NOI growth. Also, the balance sheet is in excellent shape to support growth (rated BBB+ by S&P) and the company is committed to growing dividends per share, at a rate consistent with earnings growth while maintaining a conservative payout ratio (averaging 4.5% annual dividend growth).

Federal Realty owns 105 properties including ~3,000 tenants, in ~24 million square feet, and over 2,600 residential units. The company has a highly diversified portfolio with no tenant greater than 2.7% of annual base rent (or ABR). The company’s top 25 tenants only account for 27% of ABR.

The company has the best balance sheet in the shopping center sector (rated A- by S&P) and the long-term rent growth is fueled by superior income and population characteristics and significant barriers to entry. This means the company has very high-quality properties that generate strong risk-adjusted returns – Federal Realty is the only publicly traded shopping center REIT to grow FFO per share every year since 2010.

Weingarten Realty is the “surprise standout” in our WACC exercise. Since 2015 the company has sold over 20 Power Centers out of 61 property sales that have longer-term cash flow volatility. This means the company has reduced weak tenants and replaced the rent checks with higher-quality tenants (with an emphasis on necessity-based companies).

The company has also transformed the balance sheet (zero outstanding under the $500M revolving credit line) and could invest $400 million in net acquisitions and maintain Net Debt to EBITDARe below 6.25x. Over the 9 years (2010 – 2018) the company has sold $2.9 billion and acquired $1.3 billion of property. Weingarten is rated BBB by S&P.

A Glance at Valuation

Now let’s take a quick look at valuation, utilizing the “iREIT” research lab, staring with the P/FFO multiple for each REIT:

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As you can see, Federal Realty and Regency Centers are trading at 20.6x P/FFO and 17.6x P/FFO respectively, while Weingarten appears to be trading at a significant discount. Let’s examine the dividend yield for each REIT now:

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As you can see, Weingarten is trading at double the dividend yield of Federal Realty and Regency Centers, while the Houston-based REIT has delivered the best overall profitability profile of all of the shopping center REITs. Let’s examine the payout ratio:

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Clearly, Regency and Federal Realty enjoy a better growth profile, based upon their lower payout ratio; however, we don’t consider Weingarten’s payout ratio dangerous by any stretch. In fact, our FFO/share growth forecaster suggests that Weingarten will be able to compete quite well with the two other blue chips:

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In Summary

We are upgrading Weingarten Realty to a Strong Buy, as a result of this WACC/Cap Rate exercise. This research provides evidence that Weingarten is doing something special and we see value in owning shares in such a high-quality REIT that’s not being recognized by Mr. Market.

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Source: F.A.S.T. Graphs

As in all of our Strong Buy upgrades, we forecast Weingarten to return at least 25% over the next 8-14 months. We consider cost of capital and scale to be the best catalysts for growth and this REIT is positioned to generate impressive returns. Source: F.A.S.T. Graphs

In terms of M&A, we think there should be no more than eight REITs and the top four consolidators (in our opinion) include Federal Realty, Regency Centers, Kimco Realty, and Weingarten Realty. This means we consider Retail Opportunity Investment, Urstadt Biddle, Kite Realty, and Acadia Realty prime candidates for takeover (M&A). The most logical M&A player (in our opinion) is Retail Opportunity, a west-coast focused gem, that is prime-picking for Kimco, Regency, or Weingarten.

Now stay tuned for our next cap rate article on the daily rental model, aka the Lodging REITs.

Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.

Disclosure: I am/we are long FRT, WRI, REG, ROIC, UBA, KRG, KIM, BRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.